IFR Asian Development Bank Roundtable 2017: Part 2
Keith Mullin, KM Capital Markets: Banks are comfortable taking construction risk; they’ve been doing it for a long time. Will asset managers ever get over the notion of construction risk?
Kunihiro Asai, Nikko Asset Management: Infrastructure is among the most attractive asset classes for Japanese investors. Japan has lost any semblance of yield even in the 10-year JGB [which was quoted at a yield of 0.021% on the day of the seminar, having been negative between February and November 2016].
We don’t have a base asset class for long-term investment so infrastructure is definitely one of the best candidates. But we have two challenges, both for institutional and retail investors. For institutional investors the challenge is credit risk and country risk. In this regard, the credit enhancement scheme that Terry described is really powerful and effective.
For retail investors, the challenge is liquidity. We have about 6,000 publicly offered funds sold in Japan but almost all offer daily liquidity. One solution is listing. We have infrastructure funds listed on the Tokyo Stock Exchange but only three, with AUM of about US$100m.
The more promising prospect is the new long-term investment programme we will have from next January, a cumulative type of NISA (Nippon Individual Savings Account). It’s very sticky.
If this channel becomes active and popular – some analysts are anticipating that US$4bn-$5bn per year will flow into the investment trust market – this channel is ideal to invest in infrastructure-type products. Asset managers won’t have to worry about redemption risk, about liquidity risk. I’m very positive and optimistic about future investment by Japanese investors into infrastructure projects.
Keith Mullin, KM Capital Markets: There’s an acceptance, Andreas, an assumption, at the policy level that infrastructure will get financed. In the darkened back rooms of policy-making, is that optimism mirrored by the optimism we see in public?
Andreas Dombret, Bundesbank: At the G20 level, not really, because the assumption is that markets are efficient, that there is enough competition and, especially in liquid markets like those we have today, that there is enough interest to finance attractive investments.
What we are thinking about is how we can sustain competitive markets. How can we make sure that there is growth in the market, that the market creates attractive offerings, and that there is regulation and supervision, which provides benchmarks for investors to orientate themselves.
Whether or not this will be picked up is up to the markets. I am a big believer in the markets, and the markets will make sure that they prioritise the more attractive versus the less attractive investments. It’s not for central bankers to invent instruments; our role is to make sure that regulation is strong and transparent so that the markets can find equilibrium and invest.
Keith Mullin, KM Capital Markets: At the sharp end of creating instruments, securities structures that meet the need, I am a little sceptical about the preparedness of bond investors to rise to the challenge and take up the slack in infrastructure financing. You’re very close to the market, Alexi. Is my scepticism warranted?
Alexi Chan, HSBC: What’s going to be important is that we mobilise the full arsenal of financing options in order to have a chance of achieving the very large numbers needed to meet Asia’s infrastructure requirements. The bond markets have an important role to play within that, but they’re not going to do it all on their own.
The format with which the bond markets can support these types of infrastructure financings will vary significantly. We will see increased issuance by the MDBs, including from new institutions, which I think is going to be very supportive. As Terry has mentioned, a range of infrastructure-related financings will be done by SOEs themselves, at the corporate level. There’s certainly a strong and deep market for that type of risk now in Asia.
We are also seeing a robust high-yield market developing in the Asian region, some of which will involve transactions based on specific projects or individual assets. We led an interesting refinancing for the international airport in Delhi last October, raising US$522.6m of 10-year money in the 144A/Reg S market. That’s one example of a structure for a single-asset issuer that we brought to the offshore capital markets, and which saw very robust demand from international investors.
Managing the currency risk, a point that a number of my fellow panellists have mentioned, is also going to be a key factor. In some of the Asian markets, we’re already seeing meaningful infrastructure projects being financeable in the local currency bond markets. The Malaysian ringgit market has been an example that’s often talked about, and we’ve been involved in major projects.
In fact, one of the largest power sector financing in the region in the local currency markets in recent years was the M$9bn (US$2.1bn) multi-tranche financing [for Jimah East Power in 2015] that was placed with institutional investors in Malaysia.
One big focus on the local currency side will be unlocking the potential of the renminbi market, and that’s going to play out in respect of China’s ‘Belt and Road’ initiative, which will facilitate infrastructure in the region. Many onshore renminbi bond financings currently involve relatively short-dated tenors, but this will increase over time, and the size of the market is already very meaningful.
Going forward, we will see the potential for sponsors of major Belt and Road infrastructure projects, either directly or indirectly, to be able to tap into institutional investor demand in the onshore renminbi bond market, which will be a new factor and potentially a game changer for funding Asian infrastructure.
Andreas Dombret, Bundesbank: I think we are dancing around the main issue here and that’s why I would like to be a little bit provocative, coming from the outside. It’s clear that Asia has large foreign assets. About half of the world’s savings are in Asia. But the capital markets, compared to this large amount of foreign assets, are not very well developed, so we have a mismatch.
What is really needed is for deep, liquid and efficient capital markets in order to be a home for those assets. We still have a mismatch of the amount of money that is being saved here and the effectiveness and the degree of development of the capital markets in Asia.
Alexi Chan, HSBC: Looking at the glass half full, we’ve made significant progress in Asian capital markets over the past decade. We’ve seen tenors increase, we’ve seen volumes available in a variety of markets increase, and we’ve also seen greater cross-border participation in a range of markets, which is important.
The overall project has reached some important milestones, in terms of the development of Asia’s capital markets, but there is clearly still a significant job to do to reach a position where Asia’s markets can really channel the substantial savings we have in this region into the most efficient and productive areas, and generate the returns for savers that are commensurate with the risks involved.
Andreas Dombret, Bundesbank: I would agree with that. The financial system in developing Asia is better developed and larger than in other developing countries, but it’s still quite a long way behind OECD countries. If you look across developing countries, I would fully agree but what is the benchmark? I would support you on this encouraging note but again there is some catching-up to do.
Terry Fanous, Moody’s Investors Service: I echo Alexi’s point about the development of the debt capital markets in the region.
The issue with the infrastructure market is that different pools of capital are attracted across the stages of infrastructure finance. Institutional investors – regional and from outside the region – really don’t have major problems lending to infrastructure SOEs. We’ve seen Chinese SOEs very able to issue debt, including State Grid Corporation of China’s US$5bn multi-tranche bond in April, as well as SOEs in Indonesia and other parts of the region.
There is a readily available pool of capital. Even though these companies are raising debt in order to develop greenfield projects, they are viewed as corporate risk. Their business model is well understood and investors are comfortable investing funds in that space.
Then you move across the risk spectrum and you have debt coming up for refinancing – bank debt as well as bond debt. That’s also another potential opportunity for institutional investors because this is debt coming up for maturity on the back of projects that have already gone through construction, both those that have just completed the construction phase and are well into their operating phase.
In Asia over the next five years, there is US$750bn of debt that’s coming up to maturity so that’s another potential opportunity for institutional investors.
Then you move across the risk spectrum and you start greenfield project risk. These are divided into credit-enhanced projects and pure naked greenfield projects. I talked about credit enhancements earlier on. Greenfield projects themselves also have different pools of capital interested in them.
The development phase is high risk, high return and there is a very small pool of capital interested in it. Then you go into construction-phase finance. The key issues there are risk of cost over-run, schedule delays, the credit risk of the contractor, do you have enough contingency liquidity to manage any mishaps?
You really don’t have a lot of institutional capital interested in that. That’s where the banks come in; they are very much suited for that. They have been doing it for decades and have developed an expertise that will take a long time for the institutional markets to get to.
Keith Mullin, KM Capital Markets: But if project finance banks are a source for assessing construction risk in project finance – they’re also constrained in the amount of project finance they can lend as a result of Basel regulations.
The ADB’s PPP unit has expressed concerns about how it can get deals closed if the financial sector is heavily reliant on constituents that are constrained. One of their questions is whether there is a constraint in terms of the people who can assess this risk in a way that’s trusted by the market, and ultimately how the market can get more deals flowing.
Terry Fanous, Moody’s Investors Service: There are three things I would mention. First, many institutional investors are not simply equipped with the resources to analyse the construction risk associated with greenfield projects. That’s why we have seen entities like the Credit Guarantee and Investment Facility providing construction-phase guarantees that say to institutional investors: “don’t worry about construction risk. That is supported through my guarantee. Your risk is essentially the operating-phase credit profile”.
I know a number of transactions have been established on the back of this guarantee, and I think much more can be done. But it’s a very good start.
Second, bringing in institutional investors up-front when the deal is being contemplated by governments and banks goes a long way towards allowing them to understand greenfield construction risk. Institutional investors tell us: “by the time I am told about a deal, I don’t know much about it and it’s very close to being launched”. It seems they aren’t given sufficient time to analyse the transaction. Bringing them into the tent as early as possible goes a long way towards engaging them.
Third, there’s benefit in having commercial banks provide greenfield construction financing and reselling the risk to institutional investors at the end of the construction period, which allows them to understand the risk, test it, be familiar with it, so that the next greenfield project that comes becomes a little bit more familiar for them.
For those investors, there is benefit in looping them right up-front. I don’t see why we can’t have a model where institutional investors are brought in on day one to a construction-phase facility. They don’t take construction risk but they observe the funding structure. They are able to commit that, subject to the practical completion of the project, they are able to come in and commit financing post-construction, having observed the project, the construction risk, and analysed post-completion risk.
The question is: are the banks happy to sell down risk when construction is completed? I am not sure, but I don’t think the banks will be reluctant to sell that risk. Every bank is looking very hard at recycling its capital. I hear from commercial banks their willingness to provide construction facilities and recycle that capital into other construction facilities so that they can make the most use of their capital, given Basel III.
Keith Mullin, KM Capital Markets: Do project bonds have a future in Asia? We haven’t seen many and they can be difficult to get your head around if you’re not used to that kind of structure.
Alexi Chan, HSBC: I think we’ll see a series of bespoke financings come out in the project bond space. These may initially be targeted to a small number of institutional investors where the structure can be specifically tailored to meet their requirements.
As an asset class, you’re right: Asian project bonds have not grown commensurately with the rest of the market to-date, but I think for certain bespoke structures – potentially privately placed or semi-privately placed – we will continue to see some very interesting projects come to market.
Søren Elbech, AIIB: It also depends a lot on the application of Basel III requirements in the banking system. A lot of banks have participated in the space where project bonds would typically be so have taken it on their balance sheet. When banks start to adhere to the Basel III and Basel IV environments, I think we’ll see project bonds maybe having an opportunity to survive.
Keith Mullin, KM Capital Markets: Within the broad theme of infrastructure, a key theme has been the development of green, renewable and social infrastructure.
Andreas Dombret, Bundesbank: The mandate of our organisation is the socio-economic development of developing countries. The Green bond market has rapidly developed in the past two-to-three years, backed by the Green Bond Principles.
We do some green projects but most of our projects in developing countries are social, to support basic infrastructure like transport, energy, water supply, sanitation, education, and so on. Thus, it’s a natural fit for us to do something social and to call our bonds social bonds.
Last June, the International Capital Market Association issued guidance specifically for issuers of social bonds: proceeds have to be used for social projects and have to follow the four components of the Green Bond Principles: use of proceeds, project selection and evaluation, management of proceeds and reporting.
We engage in social projects mainly for infrastructure development and our operation has been very accountable and transparent. We were comfortable that our operations followed the four components of the social bond guidance, so in August 2016 we obtained a second opinion and in September 2016 we issued social bonds.
The Japanese market for Green or social bonds has not developed as quickly as the European market. Our issue of social bonds in September 2016 was the first in Japan as a Japanese issuer so we received a lot of demand. We’ve labelled our bonds in the domestic market social bonds since then.
We didn’t label our US dollar Global social because the requirements of investors are a bit different in Europe and elsewhere. But I do hope that the Japanese Green and social bond market will develop and mature. In order to do that, the Japanese government recently prepared guidelines for Green bonds to encourage the entry of Japanese issuers into this market.
Terry Fanous, Moody’s Investors Service: In terms of the Green bond market, we saw a significant increase in issuance last year. We think that Green bond issuance could go from US$93bn last year to US$200bn this year, supported by sovereign issuance we have seen.
Keith Mullin, KM Capital Markets: Some people are sceptical about Green bonds. What can you do, as issuers, to assuage the concerns?
Andreas Dombret, Bundesbank: The global Green bond market has developed very quickly over the past 10 years. Especially in China, where there has been a huge and rapid increase in issuance. But I understand that there is still a big debate about the definition of Green bonds and their scope.
I also understand the EIB recently initiated an initiative with China. What they are trying to do is instil a sense of diversity or flexibility when it comes to the definition of Green bond and what it really means. To avoid confusing investors, there should be some common terminology or taxonomy so when somebody uses a particular word [in the context of] Green bonds, it should mean the same to all investors. This kind of initiative is very important and very welcome.
[Note: From their communiqué of March 22, 2017, “[r]eflecting the crucial role of capital markets in financing green investment”, EIB and PBOC said they “will examine current classification of Green bonds to map and compare respective approaches to green projects eligibility. This will use references including the Green Bond Endorsed Project Catalogue of the China Green Finance Committee as well as the Common Principles for climate finance tracking used by the Multilateral Development Banks (MDBs) and the International Development Finance Club (IDFC)”.
The parties will “work together to contribute to strengthening the capacity of Green bonds to improve accountability in green finance and support implementation of the Paris Agreement”.]
Andreas Dombret, Bundesbank: Germany took over from the Chinese G20 presidency so we also took over the issue of green finance, which was kick-started when China established a study group on this important topic. The objective of the G20 is to identify institutional market barriers to green finance so that we get even higher issuing amounts and deeper markets altogether.
For that you need harmonisation, and you need a clear definition of what exactly is green. We believe that what we need – and this is what the German G20 presidency is working on – is a robust and coherent set of basic information about climate risk because not many people understand what climate risk really is.
You can argue that if it’s a risk beyond the horizon and you cannot insure yourself against it, it’s a major financial risk with financial stability dimensions. So one needs basic information about the actual risk one is taking on, and investors need better tools. That’s what we are trying to come up in this study group, to help better classify green finance.
Keith Mullin, KM Capital Markets: From an asset management perspective, how do you view Green bonds?
Kunihiro Asai, Nikko Asset Management: Nikko AM is a pioneer in providing green-related bonds or socially responsible investments to Japanese retail investors. We have launched several funds investing in green bonds or bonds issued by the World Bank and their peak AUM reached around US$3bn.
But as we have been discussing, the provision of information and the definition of green are very important for investors. We are constantly asked if by investing in a green project or a green product we are sacrificing return. Our answer is: “No, of course not”.
We believe the long-term sustainability is one of the most important investment themes and the most important theme for our society. We are very aware of the importance of information provision and the clear disclosure of a definition of green, and we believe we have successfully provided such information to investors.
Terry Fanous, Moody’s Investors Service: Moody’s developed a Green bond assessment methodology a year ago to provide that transparency to the market. That methodology scores every green bond on a scale of 1 to 5 (1 being the best, 5 being the worst).
We have a rigorous framework to assess the promises that issuers make to the market and to what extent there are effective governance standards within the company to manage and allocate proceeds to green projects, and to report to investors on a regular basis.
Keith Mullin, KM Capital Markets: Do you have any Fives in your assessments?
Terry Fanous, Moody’s Investors Service: All the Green bond assessments we have issued have a score of 1. There’s a good reason for that: through discussions with issuers we discuss our Green bond assessment framework and they go away and present a framework that is aligned to “1”; it seems that issuers won’t want to come out with a Green bond assessment that is not the best.
Alexi Chan, HSBC: I think it’s a great debate to have, and thank you for raising this subject. Certainly from HSBC’s side, sustainable finance is a topic of the highest importance to us. We were involved in the drafting of the Green Bond Principles and we were also one of the earlier issuers of a Green bond ourselves. That had a significant impact on the way we thought about our lending portfolio, in relation to the specified use of proceeds of our green bond issuance.
As a leading underwriter of Green bonds, we get a lot of questions from issuers and investors on the pricing dynamics. The investor perspective is naturally concerned with whether any yield is being given up in these sorts of instruments.
From issuers we typically get the question: “What’s the benefit to me as an issuer to going through the extra reporting, putting in place specific uses of proceeds rather than general corporate purposes”? And most importantly for issuers: “Am I going to be tapping into a specific pool of capital dedicated to sustainable investment that will deliver me incremental benefits in terms of investor diversification”?
Resolving these issues will require a joint effort by a range of stakeholders. The number of our issuer clients now using second-party opinions is increasing, whether from scientific bodies such as CICERO/Sustainalytics that are now an integral part of the Green bond market, or from the rating agencies or other financial services firms. Those opinions are important in promoting greater transparency and consistency in the Green bond market.
Issuers are increasingly realising the importance of committing to a credible Green bond framework, and we’re actively supporting our clients in drafting those frameworks. I’m pretty optimistic about this initiative. When the market reaches critical mass, that’s when there are really going to be direct financial benefits for companies to engage in this sort of sustainable financing. And that’s when we’ll really be in a position where the capital markets can help transform the way companies behave in terms of sustainability.
Keith Mullin, KM Capital Markets: That’s as good a place as any to close our discussion and it’s always good to end on a positive note. Thank you very much to our distinguished panel for a wide-ranging and very insightful session.